EAT – THE MELT DOWN COULD BE JUSTIFIED, BUT AT SOME POINT……

10/15/08 03:42PM EDT

The fundamentals for the casual dining industry are horrendous. I’m not even going to rehash the issues. At some point fear trumps fundamentals and that creates opportunities. Let me say right up front that I think there is a tremendous opportunity for those with patient capital wanting to own Brinker international.First, here is the bear case – It’s worth zero - before this market is done, any company with any debt is going to be worth zero. EAT’s FY09 EBITDA declines to $250 million - put an EV/EBITDA multiple of 3.6x on it and the EV equals $900 million. Subtract debt of $900 million and the equity is worth zero. Ok so we now know the potential downside, let’s look at something a little less gloomy.

What we do know is that the industry is headed for a major shakeout, eliminating the weaker players to the benefit of the strong. To be clear, Brinker is strong and will gain significant market share over the next three to five years. Currently we have a bankruptcy watch list that includes two of Chile’s major competitors – Ruby Tuesday’s and O'Charley’s. Beyond that, every day, I read every day about smaller players closing stores. As a restaurant analyst, we have been talking about the industry’s excessive growth and the need for a shake out for five years. We are here! It’s time to take advantage of the current fear and buy assets that are trading at a significant discount to intrinsic value.

EAT has significant ability to generate cash.

To management’s credit, they have been preparing for harder times – just not fast enough. If we assume just the basic capital spending needs for the next few years EAT will generate approximately $200 million in cash each year. The equity value of the company is currently $1.1 billion. So in 5.5 years EAT will generate its current equity value in cash. More importantly, the company could pay down its $900 million in debt in 4.5 years. Lastly, assuming these basic capital spending needs, the company is trading at a free cash flow yield of 18%.

Buy a strong brand and distribution channel below replacement cost.

Owning the Chili’s distribution system is a valuable asset. EAT owns the valuable real estate underneath 22% of all of its stores (including land and building). For the 282 restaurant locations EAT owns, the net book value for the land was $241.2 million as of the end of FY08 and for the buildings was $237.0 million. For the remaining 983 restaurant locations, which the company leases, the net book value of the buildings and leasehold improvements was $977.6 million. The company’s total enterprise value is $1.9 billion relative to its restaurant locations’ net book value of nearly $1.5 billion, which means the market sees very little value in the cash flow of this business right now.

In today’s environment owning real estate may not mean much, but in three years it will. It would be impossible to rebuild the Brinker restaurant distribution system, but if you could it would cost $2.2 billion to rebuild Chili’s, $350 million for OTB and over $400 million for Maggiano’s. Again, today the enterprise value of the company is $1.9 billion.

Selling assets

Over the past two years Brinker’s management team has been trying to sell off assets to become more of a franchised organization. If the world returns to a normal environment, EAT will be able to sell more assets. I calculate that EAT could sell assets worth $1.0-$1.5 billion, nearly matching the entire enterprise value of the company. Once the asset sales are completed you are still left with a more efficient store base and a very valuable royalty stream.

I know the restaurant industry’s current environment sucks, but that is the opportunity. The Chili’s brand is one of the best in the business and will be for decades. In this environment the company is perfectly positioned to capture incremental market share as other restaurant companies can’t compete in the current environment. There is probable no better time to take advantage of buying a premier company trading at a significant discount to its intrinsic value.